Trusts created by a Will
Written by Ray Coman
Capital gains tax for Trustees
Inheritance tax on lifetime transfers
Disposal of rights by life tenant
Interest in Possession Trust
Trustees of an interest in possession trust have no discretion to accumulate income in the trust fund. Beneficiaries are automatically entitled to Trust income with Trustees acting as mere agents.
Trust Return requirement
Where income is mandated directly to the beneficiary, there is no need to file a Trust Return (SA900.) However, Trust expenses cannot be deducted from taxable income. In some cases, for instance with a managed portfolio of assets or a buy to let property, the constituents of Tax Return are the same as those where the asset is owned directly. Larger Trusts tend to be specially managed, and a Trust Return is warranted by the deductibility of Trustee management expenses. The Trust is taxed at the basic rate on income regardless of the amount of Trust income.
Immediate Post Death Interest
Immediate Post Death Interest arises from an Interest In Possession (IIP) Trust created by a Will. Typically, the life tenant receives a right to enjoy the benefit of an asset until death, at which stage the asset passes to a remainderman. The life tenant has a life interest and remainderman is the capital beneficiary. A typical example is where a surviving spouse will receive letting income with the property eventually passing to the children on death of both parents. The Will protects the benefits of descendants even if the surviving spouse remarries.
Tax treatment of settlor
Where the beneficiary of a Trust is a spouse or civil partner, the transfer is exempt from inheritance tax. This matches the spousal exemption rule for direct transfers. By exception where the transferor is UK domiciled and the transferee is a non-domiciled spouse the exemption is limited to the nil rate band. Where the Trust beneficiary is not a spouse, transfers from the estate are chargeable to inheritance tax.
Section 62 of the TCGA 1992 confirms that death is not an occasion that gives rise to CGT. Therefore, the settlor will not be liable to capital gains tax on appointment of assets to a Trust. Probate value establishes the base cost for future transfers.
IHT for life tenant
Where an interest in possession Trust is created by occasion of the settlor’s death, the Trust is “qualifying.” Trust assets are part of the estate of the life tenant. The assets are referred to as “settled property” and tax is payable by the trustees.
The Trust is not subject to any ten-year charges or exit charges to inheritance tax. This is because Trust assets are not treated as relevant property.
Capital gains tax for Trustees
Death creates a tax-free uplift in value for the life tenant as well. Therefore, the Trust will not be liable to capital gains tax on the appointment of assets to the remainderman on eventual death of the life tenant.
The exception to the above occurs where gains are held over when first transferred into the Trust. Hold over relief typically only applies to business assets. It is only the amount of gain held over that would be subject to capital gains tax on death of the life tenant. (TCGA 1992, s.74(2)).
It is possible for both the settlor and life tenant to avoid capital gains tax through an interest in possession trust created on death. However, both parties would be subject to inheritance tax. If the life tenant were the spouse of the settlor, the initial transfer would be exempt from inheritance tax. A spouse also inherits any unused nil rate band of the deceased husband or wife.
If settled property is disposed of during the lifetime of the life tenant, capital gains tax liability arises on the difference between consideration and probate value. If the asset is sold to a third-party, consideration will be sale proceeds, less relevant costs. Where appointed to the capital beneficiary before the death of the life beneficiary, consideration will be market value at the date of transfer.
Some Trusts give power to trustees to appoint settled property to the capital beneficiary dependent on an event or age being reached.
The capital gains tax regime for Trusts closely mirrors that for individuals. The exception is that Trustees only obtain half of the annual exemption. The exemption is further divided by the number of Trusts created by the same settlor, subject to a limit of a fifth of the annual exemption for Trusts.
Trust can claim Principal Private Residence relief on the disposal of residential property occupied by the life tenant.
Hold over relief
Holdover relief is sometimes referred to as section 260 which refers to the IHTA 1984. The relief is not automatic and has to be jointly elected by the Trustee and beneficiary.
The gain is held over and taxed on the beneficiary on eventual disposal. Tax benefits arise were the beneficiary is subject to CGT at a lower rate than the Trust.
A trust which is set up on the death of a parent is known as a ‘bereaved minor’ Trust. The minor is entitled to Trust property on reaching a certain age. In this case, the Trust can use hold over relief so that there is no immediate charge to capital gains tax on distribution of the asset. Hold over relief is also available on the transfer of business assets, such as shares in an unquoted company.
Hold over relief is not likely to apply to other capital distributions made by an interest in possession Trust. Lack of relief is a deterrent from appointing settled property prior to death of the life tenant.
Inheritance tax on lifetime transfers
Where the Trust distributes an asset prior to the death of the life tenant, the transfer is referred to as a Potentially Exempt Transfers (or PET.) Broadly, the value of the asset transferred will not form part of the life tenant’s estate if that individual survives seven years.
Gift with reservation
Where the beneficiary continues to enjoy a pre-owned asset, it is regarded as part of the estate for inheritance tax purposes. A typical example is where an individual gifts property to their children but continues to live in the property rent-free. Therefore, a PET has not been made where the life tenant continues to benefit from the property that was previously settled in the Trust.
Disposal of rights by life tenant
The right to future income by a life tenant has value. The acquirer obtains entitlement to future Trust income. The disposal of this right by the old life tenant does not give rise to capital gains tax. The Trust remains liable to capital gains tax on disposal or appointment of settled property. The new life tenant is potentially subject to tax on any income produced by the Trust. Subsequent disposal of rights by the new life tenant give rise to capital gains tax and the exemption does not apply to Trusts that are not UK resident.
A Protective Trust prohibits a life tenant from selling their interest.
